The S&P 500 index lost the support of its long term moving average on May 20th. Many technical traders watch this level and react to it, making it a critical pivot. But does losing the 200 day moving average, forebode dark times ahead for the stock market?

We know from historical studies that the 200 day moving average is your friend. But keep in mind that its slope is still trending up. And we haven’t had the 50 day moving average fall down below it in a “Death Cross”. To me, those would be very ominous developments.

Taking a relatively long term look at the movements of the S&P 500 index in relation to its long term moving average shows that it has been here before and that within the confines of an uptrend (a cyclical bull market) this has indicated a buying opportunity.

It is only during severe bear markets that we see price crash well below its 200 day moving average. If you’ve just found the blog, you probably weren’t around when I used this same metric to point out the eye-popping extreme oversold: Another reason we’ve seen the market low.

Now the S&P, for example, has dipped below its 200-day moving average. That is a red flag for a lot of technicians and a lot of technicians will actually act on that signal and get out of the market. We did a study that had some interesting results. Since 1972, when you’ve been in a sustained uptrend, like we had been believe it or not before May, if you’ve been above the 200-day moving average for six months in a row or longer and you get this kind of a pullback, you actually see some significant out performance in the subsequent months.

So three to six months out, for example - you get - six months out, you get 8% plus gain in the S&P. Three months out you get 4% plus gain in the S&P, more than double what the market normally does over periods like that. So scary pullbacks in the context of a bull market are often buying opportunities if you can just take a deep breath and buy. I will suggest though there was one point in the past, in 1987, October, we all know that month, where that particular indicator didn’t work. So you want to be long, but you want to look for hedges as well.

Now having said that, we haven’t been this far below the 200 day moving average for a while. The last time was about a year ago in late May 2009. But back then, the 200 day moving average was falling precipitously and price was rising. That’s not what is happening now.

A more analogous time is late 2007 when the long term average was still trending higher and price was breaking under it after having successfully ricocheted off it several times in the previous years. Here is a zoomed in chart showing the recent price action:

As well, keep in mind that we are seeing considerable deterioration in technical metrics like the percentage of stocks above their 150 day moving average. After yesterday’s weak close, that measure closed at 27% - the lowest since early April 2009. The key distinction, and one that Schaeffer reiterates, is whether we are still in an intermediate uptrend or whether the trend has changed. Based on this breadth indicator, it is difficult to argue that the market still has the wind at its back.

Finally, if you haven’t already, you should read the report from Dick Arms about the spike in the Arms index to 13.22 - his conclusion, not surprisingly is that we are extremely oversold and due for an imminent rally:

In summary, the current selling is very overdone. The broader market is in a sideways move, having broken down from the uptrend that lasted over a year. We are back down to the support of the sideways area in the market. Breaking that level decisively would put us in a bear market, but I do not think that is likely, at least yet. The extremely high Arms Index on Friday has a history of calling turning points. It also puts the moving averages into extreme oversold positions. Volume is still heavy, which is to be expected on lows. Volatility is high. All these factors suggest an imminent rally.

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Babak, it seems that you are on a roll recently. Does this have to do with the extreme volatility of the markets (meaning that you want to add you 2 cents) or is this something we can expect to see in the future (more time on your hands, perhaps?) as well? In any case, thank you for the great info and analysis. Your blog has been a real launching pad for me in terms of looking into different indicators in more detail, especially market internals. I’m sure there are many others out there like me who have benefited hugely from your blog.

I think Mike was looking for the specif setting of the PPO. Correct me if I’m wrong wrong, but I think the setting is 1,200,1 for the 200 dma. If you want a relative indicator for X period dma, you just use the 1,X,1 setting. Babak?

You are being too modest, Babak. This isnt inspired work, so much as very thorough journalism, compiling thought pieces across different viewpoints.

The ‘perspiration’ percentage of such work far outweighs the ‘inspiration’ element, for all that both are necessary. In old newshound terms, one has to “slap shoe leather on the pavement”. Is there anything you dont have a subscription to?

Babak,
Another great post - as always.
I went through your 2009 post (”Another reason we’ve seen the market low”) again and found an amazing thing - “almost” all comments in the comments section then were pessimistic. Even the semi-optimistic ones had a pessimistic note in them.

Its amazing how much bearishness was present in the market in march-april 2009 and the rally we have had since then. I now appreciate your post then even more.

And what else is amazing is some of the indicators now (not all ofcourse) are almost at as much extreme levels as at nov 2008 / mar 2009 levels.

Would you also consider the fact that VIX has not made a higher high (yesterday’s high of 36 vs. May 2010 high of 48) as another “positive divergence”? Could an explanation be that the Smart Money bought puts early on (pushing the VIX up to 48) … now, the SPY makes a final price low (due to Dumb Money selling), while the Smart Money already has (put) protection in place?

Very good, I agree w/ your analysis of 200ma, however there are a few differences on this drop under the 200ma that I cannot find in the Dow going back to 1900.

I also agree with you that the market is oversold enough that a rally could start at anytime but even with today’s test of 1040 in sp5, I don’t yet see enough technical evidence yet that it will start this week, although I closed out my TZA position in the 1st half today.

The differences that I see in the market may be corrected when/if a rally starts and I will change my opinion but I do think that “this time it’s different”

hey guys..
well, time frame is not important here, I ‘m focused in the las bull market since march 09, you know, small caps led the recovery and called bottoms over the last year or so.. so now I think the Rusell itself will show us the way to go, and looking at the last few days, it totaly underperformed the SP (along with the NDQ100).. so when looking for breadth, I’d start looking here first.. and I don’t see any buy signal here yet.
technically speaking, next support is like a 10% below..so I’m with Jack, It won’t hold 1040, and it will get worst before it gets any better, and tomorrow would be “the day”.. really ugly what they did today..
BTW, I totally agree with the 200MA as an advantage.. (I learn that recently hehe)
Great Bog BTW.
Regards from Argentina

Thanks Tony. was curious how you were looking at it. I use technical to anticipate the very short term and fundamental to support a 12-24 month view. In short run (1-3 months), I dont see much support for anything. The volatility will remain and we’ll test more lows. I combine fundamental analysis with technical side, the latter establishing the short run support levels and the former setting up clear values for the SP. On my fair value FUNDAMENTAL model for SP, I can see a floor of 880-920 (think SP500 op EPS is going to be lower than current estimates for ‘10 and ‘11 by a solid margin, esp 2011 and I apply a PE based on where Baa is/expect it to go over NTM). When fundamentals/confidence deteriorate (or are expected to)- multiple compresses and pushes a lower and opposite occurs Technically, the SP500 is not pointing to the 880-920 range yet, but easily could as key support levels break in short . The upside remains in 1250-1300 range once fundamental picture becomes more clear and confidence returns. So I try to play within that band 880/920 low and 1250-1300 high over 12 month period. In 2009, this model supported a 720 low - 980 high band, which wasnt too far off, and played accordingly. anytime the SP hit the extremes of this band (or broke out of it), it became a signal to sell or buy aggressively. Of course back then, there was more uncertainty to what the SP EPS (for 2010, more importantly) was really going to look like. and it took some guts to buy stuff in March/April 09 when the pundits were calling for SP500 to hit 500!

Getting back to IWM. your point caught my attention, cuz I am a big believer in reversion to the mean. small caps remain over-owned in institutional portfolios and the out-performance over large caps has been very clear (pick any time frame 1 year or longer). at some point, this leadership will shift and the IWM wont be the indicator of which way the market goes and large caps will. This is a trickier inflection point to identify but the IWM lagging could be an early indicator of this shift happening.